The Obvious Reason QE Doesn’t Work

Why QE Is a Dud

Paul Gambles – the managing partner of MBMG Group – explains at CNBC, there is an obvious flaw in QE:

BoE’s Quarterly Bulletin … states that a “common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach.”

This “misconception” is obviously shared by the world’s policymakers, including the U.S. Federal Reserve, the Bank of Japan and the People’s Bank of China, not to mention the Bank of England itself, who have persisted with a policy of quantitative easing (QE).

Indeed, Ben Bernanke might have had hints about the flaw in the money multiplier theory back in 1988.

Gambles continues:

QE is seen by its adherents, such as former U.S. Federal Reserve Chairman Ben Bernanke, as both the panacea to heal the post-global financial crisis world and also the factor whose absence was the main cause of the Great Depression. This is in line with their view that central banks create currency for commercial banks to then lend on to borrowers and that this stimulates both asset values and also consumption, which then underpin and fuel the various stages of the expected recovery, encouraging banks to create even more money by lending to both businesses and individuals as a virtuous cycle of expansion unfolds.

The theory sounds great.

However it has one tiny flaw. It’s nonsense.

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Professor Hyman Minsky was one of the first to recognize the flaw in those theories. He realized that in practise, in a credit-driven economy, the process is the other way round. The credit which underpins economic activity isn’t created by a supply of large deposits which then enables banks to lend; instead it is the demand for credit by borrowers that creates loans from banks which are then paid to recipients who then deposit them into banks. Loans create deposits, not the other way round.

But Gambles notes that central bankers are trying to salvage the reputation of QE as an economy-saver by relying on interest rates:

In the BoE’s latest quarterly bulletin, they conceded this point, recognizing that QE is indeed tantamount to pushing on a piece of string. The article tries to salvage some central banker dignity by claiming somewhat hopefully that the artificially lower interest rates caused by QE might have stimulated some loan demand.

However the elasticity or price sensitivity of demand for credit has long been understood to vary at different points in the economic cycle or, as Minsky recognized, people and businesses are not inclined to borrow money during a downturn purely because it is made cheaper to do so. Consumers also need a feeling of job security and confidence in the economy before taking on additional borrowing commitments.

In addition, lowering interest rates through quantitative easing may well create a trap. And former FDIC chair Sheila Bair notes:

“The Fed has got the best of intentions…but it’s counterintuitive,” she argues. “Low rates dampen the incentives to invest.”

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Banks can make money in other ways – trading profits, investment banking fees, deposit accounts – other ways…that don’t necessarily help the economy.”

It may even be that QE has actually had a negative effect on employment, recovery and economic activity.

This is because the only notable effect QE is having is to raise asset prices. If the so-called wealth effect — of higher stock indices and property markets combined with lower interest rates — has failed to generate a sustained rebound in demand for private borrowing, then the higher asset values can start to depress economic activity. Just think of a property market where unclear job or income prospects make consumers nervous about borrowing but house prices keep going up. The higher prices may act as either a deterrent or a bar to market entry, such as when first time buyers are unable to afford to step onto the property ladder.

Dr Andrea Terzi, Professor of Economics at Franklin University Switzerland, also suggests that many in the banking and finance industry, who often have trouble with the way academics teach and discuss monetary policy, will find the new view much closer to their operational experience.

The Federal Reserve official responsible for implementing $1.25 trillion of quantitative easing has confirmed that QE is just a massive bailout for the rich:

I can only say: I’m sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed’s first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I’ve come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.

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Trading for the first round of QE ended on March 31, 2010. The final results confirmed that, while there had been only trivial relief for Main Street, the U.S. central bank’s bond purchases had been an absolute coup for Wall Street. The banks hadn’t just benefited from the lower cost of making loans. They’d also enjoyed huge capital gains on the rising values of their securities holdings and fat commissions from brokering most of the Fed’s QE transactions. Wall Street had experienced its most profitable year ever in 2009, and 2010 was starting off in much the same way.

You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2. Germany’s finance minister, Wolfgang Schäuble, immediately called the decision “clueless.”

That was when I realized the Fed had lost any remaining ability to think independently from Wall Street.

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